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Delaware, Confidential Arbitration and the Risk to Investors (Part 4)

As for the constitutional challenge to the system of confidential arbitration, a hearing was held yesterday.  A summary of the hearing is here.  According to statements at the hearing, six companies have used the confidential arbitration process. 


Delaware, Confidential Arbitration and the Risk to Investors (Part 3)

To the extent that a "consent" to arbitrate a "business dispute" appears in an operating agreement, members with claims against the entity may find themselves subject to confidential arbitration in Delaware.  Why does this matter?

Generally arbitration agreements (even mandatory ones) provide a mechanism for selecting the arbitrator that gives both sides a role.  Sometimes both parties must agree on the choice.  Sometimes they each select one arbitrator and the anointed arbitrators pick a third. 

With respect to FINRA actions, where arbitration is mandatory, parties receive a list of arbitrators and can strike those viewed as unacceptable. As FINRA provides:

for claims over $100,000, FINRA will send parties three lists of 10arbitrators randomly generated by the computerized Neutral List Selection System (NLSS)—10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. Under the majority-public panel method, each party may strike up to four arbitrators oneach list; under the optional all public panel method, each party may strike up to fourarbitrators on the chair-qualified public arbitrator list and on the public arbitrator list. However, under the optional all public panel method, each party may strike up to all ofthe arbitrators on the non-public arbitrator list. After striking arbitrators from the lists, theparties will rank the remaining arbitrators in order of preference and FINRA will appoint thepanel from among the names remaining on the lists that the parties return.

This is not, however, how things work with respect to confidential arbitration in Delaware. 

Rule 97(b) provides that upon receipt of a petition for arbitration, "the Chancellor will appoint an Arbitrator."  Arbitrator in turn is defined in Rule 96.  The term includes "a judge or master sitting permanently in the Court."  In other words, the parties will be assigned an arbitrator from those on the Court.

The identity of the arbitrators has been viewed as something important to "business citizens."  The amicus brief written by the Corporation Section of the Delaware Bar specifically noted that the loss of confidentiality for the proceedings would cause "business citizens" to seek alternatives, thereby depriving them of "efficient dispute resolution before their preferred expert."

These same arbitrators, while the "preferred expert" for "business citizens" may not be the "preferred expert" for investors or shareholders.  Members in an LLC who are subject to confidential arbitration may, therefore, find themselves in a forum with a decision maker that they otherwise would not have selected.   

Moreover, while the "consent" has appeared in operating agreement, it may eventually surface in a company's bylaws or articles, much the way mandatory venue provisions have surfaced.  See In re Revelon Inc. Shareholders Litigation, 990 A.2d 940, 960 (Del. Ch. 2010) ("if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes."). 

Shareholders, members, and other investors could, therefore, wake up and find that their disputes with the company were subject to confidential arbitration from an arbitrator that was the "preferred expert" of business citizens but not their preferred expert in a forum whereby the right of appeal is limited.  It may be a rude awakening.  


Delaware, Confidential Arbitration and the Risk to Investors (Part 2)

We are discussing the system of confidential arbitrations for business disputes that was recently put in place in Delaware. 

To take advantage of the system of confidential arbitration, the parties must consent, one must be a "business entity," a party must be organized under the laws of Delaware or have their headquarters in the state, and, where the action is seeking only monetary damages, must allege an amount of at least $ 1 million.  In addition, the provision does not apply to actions involving consumers.  Consumer includes "an individual who purchases or leases merchandise primarily for personal, family or household purposes." 6 Del. C. § 2731. 

Rule 96 defines "consent to arbitrate" as "a written or oral agreement to engage in arbitration in the Court of Chancery and shall constitute consent to these rules."  The definition also provides magic language that will trigger application of the system of confidential arbitration.  According to the Rule:  "[A] consent to arbitrate is acceptable if it contains the following language:  The parties agree that any dispute arising under this agreement shall be arbitrated in the Court of Chancery of the State of Delaware". 

Parties seeking to invoke confidential arbitration may, presumably, consent to do so at any time.  Consent may also appear in an agreement.  See COMPREHENSIVE SETTLEMENT AGREEMENT Between Versata  and Selectica, Sept. 2011 ("Any and all disputes between the Parties, whether arising out of the Agreement or otherwise, shall be submitted to binding arbitration in Delaware under the auspices of the Delaware Chancery Court pursuant to 10 Del. C. Section 349, with the proviso that the arbitration be heard before a current judge who shall render an opinion in accordance with the law."). 

There is nothing in the statute or rules that requires the consent to be in an agreement executed by two businesses.  Indeed, the provisions require that only one of the parties be a business.  Consents, therefore, may appear in agreements that involve individual investors or shareholders (although not consumers).  Moreover, these types of consents are beginning to appear in LLC operating agreements.  According to one Limited Liability Agreement:  

The Members hereby agree that any dispute among the Members or Committee Representatives as to how to proceed under this Section 7.4 shall be arbitrated in the Court of Chancery of the State of Delaware, pursuant to 10 Del. C. § 349 and the Rules of the Delaware Court of Chancery. The parties hereby submit to the exclusive jurisdiction of the Delaware Court of Chancery in connection with any action to compel arbitration, in aid of arbitration, or for provisional relief to maintain the status quo or prevent irreparable harm prior to the appointment of the arbitrator. 

Similarly, another Limited Liability Company Agreement provided that:  

Any dispute, claim or controversy arising out of or relating to this Agreement that cannot be resolved amicably by the parties, including the scope or applicability of this agreement to arbitrate, shall be determined by binding arbitration pursuant to Section 349 of the Rules of the Court of Chancery of the State of Delaware if it is eligible for such arbitration.

In other words, members of LLCs with disputes arising from their ownership interest may find themselves subjected to mandatory confidential arbitration in Delaware.  We will discuss why this matters in the next post.

Primary materials are located at the DU Corporate Governance web site. 


Delaware, Confidential Arbitration and the Risks to Investors (Part 1)

In 2009, the Delaware Legislature adopted Section 349 of the Delaware Code (House Bill 49).  The provision permitted the use of confidential arbitration in "business disputes." 

What made the provision unique was the identity of the arbitrator.  The provision provided that the Court of Chancery had "the power to arbitrate business disputes when the parties request a member of the Court of Chancery, or such other person as may be authorized under rules of the Court, to arbitrate a dispute."  10 Del. C. § 349. In effect, therefore, parties would get the benefit of one of the Chancellors/Vice Chancellors at the Delaware Chancery Court (or one of the court masters). 

The Chancery Court has adopted implementing rules.  Chancery Court Rules 96-98.  At least two companies have already made use of the Rule, filing a confidential arbitration with the Chancery Court.  See Form 10-Q, Mattersight Corporation, Nov. 10, 2011, at 14 ("On October 25, 2011, an arbitration hearing between the Company and TCV (as defined below) took place before the Court of Chancery of the State of Delaware").  Chancellor Strine presided over at least one of the proceedings.  As one public filing described:

On October 31, 2011, Chancellor Strine of the Court of Chancery of the State of Delaware, acting as arbitrator in the arbitration proceedings between Skyworks Solutions, Inc., a Delaware corporation (“Skyworks”) and Advanced Analogic Technologies, Incorporated (“AATI”) regarding the parties’ May 26, 2011 Merger Agreement (the “Merger Agreement”), held a hearing on Skyworks’ request (reported in the Current Report on Form 8-K filed by Skyworks on Friday, October 29, 2011) to file an amended petition alleging certain additional matters. After the hearing, Skyworks filed the amended petition.

The case eventually settled.

The adoption of the system of confidential arbitration that relied on members of the Chancery Court has generated controversy.  The Delaware Coalition for Open Government has challenged the constitutionality of the system.  The DCOG alleged that the system violated the First and Fourteenth Amendment.  In effect, the Complaint asserts that there is a constitutional right to access to trials and that the the approach adopted by Delaware violates that right.  According to the Complaint:

Del. C. §349 and Chancery Court Rules 96, 97 and 98 deny plaintiffs, and the general public, their right of access to judicial proceedings and records. Although the statute and rules call the procedure “arbitration,” it is really litigation under another name. Although procedure may vary slightly, the parties still examine witnesses before and present evidence to the Arbitrator (a sitting judge), who makes findings of fact, interprets the applicable law and applies the law to the facts, and then awards relief which may be enforced as any other court judgment. The only difference is that now these procedures and rulings occur behind closed doors instead of in open court.

As a result, the system, according to the Complaint, constitutes "constitute an unlawful deprivation of the public's right of access to trials in violation of the First Amendment as applied to the states by the Fourteenth Amendment to the United States Constitution."

The system and the case brought by the DCOG has already generated some commentary.  This includes posts at the ADR Prof Blog and Prawfsblawg

At the same time, the litigation has generated interest from interest groups.  Nasdaq/NYSE has filed an amicus on the side of Delaware, supporting the constitutionality of the system, as has the Corporation Section of the Delaware Bar Association.  An amicus has been filed supporting the position take by the plaintiff by the Reporters Committee for Freedom of the Press and five other news organizations. 

The first amendment issue is an interesting one but beyond the competency of this Blog.  While arbitrations are typically confidential, the main issue is whether, given the role of the Chancery Court, this is really an arbitration or a trial.  

There is, however, a significant issue with the Delaware approach that is within the competency of this Blog.  The approach may be available to require investors to arbitrate disputes with management.  We will discuss how this might occur in the next post.

Primary materials are located at the DU Corporate Governance web site.


SEC v. Gupta: SEC Charges Director, Hedge Fund Manager in Insider Trading Scheme

On October 26, 2011, the Securities and Exchange Commission (“SEC”) brought suit in Federal District Court against Rajat K. Gupta and Raj Rajaratnam, charging the two men with insider trading under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Section 17(a) of the Securities Act of 1933 (“Securities Act”).  The SEC previously brought an administrative proceeding against Gupta based on the same conduct; that proceeding was later dismissed.

According to the SEC’s complaint, Gupta was a member of the board of directors at Goldman Sachs and at Procter & Gamble in 2008 and 2009.  Rajaratnam managed Galleon Management, LP (“Galleon”), a hedge fund in which Gupta had a financial interest.  The SEC alleged that during 2008-09, Gupta disclosed material non-public information to Rajaratnam, who then traded on that information.  Gupta allegedly provided Rajaratnam with confidential financial information ahead of Goldman Sachs’ second and fourth quarter 2008 financial results, as well as tipping him ahead of the public announcement of Berkshire Hathaway’s third quarter 2008 investment in the company.  In addition, Gupta allegedly provided Rajaratnam with confidential financial information ahead of Procter and Gamble’s fourth quarter 2008 financial results.  Rajaratnam allegedly traded on the information. 

Under the “classical theory” of insider trading, an insider and outsider breach a fiduciary duty to shareholders when the insider knowingly or recklessly discloses material non-public information to the outsider, and the latter knows or should know of the breach.  The SEC alleged that Gupta learned insider information in his capacity as a director of Goldman Sachs and Procter & Gamble, that he knew or recklessly disregarded that the information was confidential, and that he provided the information to Rajaratnam with the expectation of a benefit.  Rajaratnam, in turn, allegedly knew or should have known that the information he received constituted a breach of Gupta’s fiduciary duties to keep the information confidential.

The SEC is seeking to permanently enjoin both Gupta and Rajaratnam from taking similar actions in the future, to bar Gupta from serving as an officer or director of a public company, and to enjoin Gupta from associating with broker dealers and investment advisers.  In addition, the SEC is seeking disgorgement of all profits and avoided losses stemming from the actions, as well as civil penalties. Gupta has sought to block the use of wiretap evidence in the case.

The primary materials for the case are available on the DU Corporate Governance website

A previous series of posts on the SEC’s administrative proceeding against Gupta is here.

Finally, Gupta's legal difficulties are not limited to the SEC case: the United States has indicted Gupta for conspiracy to commit securities fraud.


Lincoln Nat’l Life Ins. Co.: Life Insurance Policy without Insurable Interest is Void

In Lincoln Nat’l Life Ins. Co. v. Joseph Schlanger 2006 Insurance Trust, C.A. No. 178 (Del. Sept. 20, 2011), two separate insurance companies filed suit against two trusts, alleging multi-layered trust schemes that allowed a third party to speculate on the beneficiary’s life.  

In the case involving the Joseph Schlanger 2006 Insurance Trust, Lincoln National Life Insurance Company (“Lincoln”) issued a $6 million life insurance policy for Joseph Schlanger with the Schlanger Trust as the beneficiary.  This insurance policy contained an incontestability clause, which stated that Lincoln would not contest the policy after it had been in effect for two years from the issue date.  Schlanger died more than two years after the policy’s issue date, at which time Lincoln learned that Schlanger was no longer the beneficiary of the trust. Instead, Schlanger had sold his interest in the trust to GIII, a private investing entity.  GIII paid all the premiums and then used the trust to speculate on Schlanger’s life. The District Court for the District of Delaware consolidated this case with PHL Variable Insurance Co. v. Price Dawe 2006 Insurance Trust, C.A. No. 10-964-BMS (D. Del. Nov. 12, 2010), which also involved a life insurance policy that lacked an insurable interest.  The court then certified the following question to the Supreme Court of Delaware: “Can a life insurer contest the validity of a life insurance policy based on a lack of insurable interest after expiration of the two-year contestability period set out in the policy as required by 18 Del. C. § 2908?”

To answer this question, the Supreme Court of Delaware looked at the origins and purpose of the incontestability provision.  These provisions were first created to encourage potential customers to buy insurance policies.  Life insurance companies included these clauses to ensure that after the customer paid the premium on the policy for a number of years, the company would not contest the policy due to innocent misrepresentations in the application.  With this in mind, the court determined that the language of Section 2908 of the Delaware Insurance Code makes the incontestability period of the policy directly contingent on the formation of a valid contract.  Because this contract lacked an insurable interest and violated Delaware’s public policy against wagering, the policy was void ab initio under Delaware common law.  Therefore, the court held that an insurer “could challenge the enforceability of a life insurance contract after the incontestability period on the basis of a lack of an insurable interest.”

The primary materials for this case may be found on the DU Corporate Governance website.


NYSE Rule 452 and Voting Uninstructed Shares (Part 3)

The position set out in the NYSE Information Memorandum clarified that brokers will not be allowed to vote uninstructed shares for certain types of corporate governance proposals that are supported by management.  This recognizes that management support for a particular proposal is not always in the best interests of shareholders.  By eliminating the right of brokers to vote uninstructed shares in these circumstances, proposals approved by management will likely lose the automatic support that came from at least some of the brokers voting uninstructed shares. 

At the same time, this puts the NYSE in the middle of a potential quagmire.  Presumably the NYSE will have to define the particular proposals that fall within the definition of corporate governance.  This will no doubt entail an annual analysis.

The NYSE shift raises once again the question of whether Rule 452 ought to simply bar brokers from voting uninstructed shares.  The main advantage seems to be the need to have the shares present at the meeting for quorum purposes.  But this justification seems doubtful.  In some states, the quorum can be set at almost any percentage.  It is not uncommon for companies to have quorum percentages of one third.  See Del. Code § 216 ("in no event shall a quorum consist of less than 1/3 of the shares entitled to vote at the meeting"). 

Any company depending upon uninstructed shares to meet a quorum requirement of 33% has not done a particularly good job at getting shareholders to attend the meeting (by proxy or otherwise).   Moreover, the uninstructed shares could represent a sizable percentage of the 33% that are present at the meeting.  Because they cannot vote on many matters (corporate governance proposals, uncontested elections for the board, etc) the company is effectively deciding these issues through the vote of a very small percentage of the remaining shares.  It is not at all clear that a meeting should be held under these circumstances. 

At a minimum, the NYSE should conduct an empirical study to determine how often uninstructed shares are needed to ensure the presence of a quorum.  The data may suggest that they are not necessary.  To the extent, however, that they are, a second best alternative would be to allow shareholders to vote only on one matter, the outside accounting firm.  Most companies (but not all) submit the auditor to shareholders for approval.  The vote is never controversial and auditors are routinely approved with percentages above 95%.   For a more detailed discussion of shareholder approval of the auditor, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.


NYSE Rule 452 and the Problems of Uninstructed Shares (Part 2)

Rule 452 sets out the standards for voting shares by brokers.  It starts with the presumption that they can vote uninstructed shares then includes a list of matters that are excluded. 

The Rule has been at the center of controversy.  Most recently, the NYSE amended the Rule to prohibit brokers from voting in uncontested elections to the board of directors.  With majority vote provisions and "just say no" campaigns, votes by brokers in uncontested elections could carry dispositive weight.  In the "just say no" campaign against directors at Disney, some of the candidates apparently received a majority only because of the uninistructed shares voted by brokers.  Congress also stepped in by essentially requiring this result in Dodd-Frank. 

Most recently, the NYSE issued an Information Memo essentially containing further limits on the right of brokers to vote uninstructed shares.  The Memo noted that "[i]n the past, the Exchange has ruled certain corporate governance proposals as 'Broker May Vote' matters for uninstructed customer shares when the proposal in question is supported by company management."  Not any more.  Pointing out the "public policy trends disfavoring broker voting of uninstructed shares", the NYSE determined: 

that it will no longer continue its previous approach under Rule 452 of allowing member organizations to vote on such proposals without specific client instructions. Accordingly, proposals that the Exchange previously ruled as “Broker May Vote” including, for example, proposals to de-stagger the board of directors, majority voting in the election of directors, eliminating supermajority voting requirements, providing for the use of consents, providing rights to call a special meeting, and certain types of anti-takeover provision overrides, that are included on proxy statements going forward will be treated as “Broker May Not Vote” matters.

As a result, brokers will cease to have a role in the approval of certain types of corporate governance proposals.  We will discuss the implications of this proposal in the final post.


NYSE Rule 452 and the Problems of Uninstructed Shares (Part 1)

NYSE Rule 452 has always been a bit of an anomaly.  With the rise of street name accounts, most shareholders no longer hold record title to their shares.  Instead, they are held in the account of a broker (or bank).  The broker or bank typically transfers the shares to a depository, typically DTC.  So it is DTC that had record title to the shares.  

Under state law, voting rights belong to record owners.  DTC, however, does not want the voting rights.  Instead, the depository routinely (but not always) transfers voting rights to the brokers and banks that have deposited the shares.  At the time of a meeting, therefore, it is the broker that for the most part has the legal right to vote shares.

A complicated set of rules requires that brokers pass voting rights to street name owners.  They typically do so by distributing voting instructions to the account holders.  These instructions are executed then returned to the broker.  The broker will total up the votes and send the company a proxy card that reflects the views of street name owners.  For a discussion of this system, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The system gives street name ownes a guaranteed opportunity to vote at shareholder meetings even though they are not record owners for state law purposes.  Many street name owners, however, do not return their voting instructions.  Without some kind of regulatory or contractual intervention, brokers can vote the shares.  This gives them a potentially significant role in shareholder decisions even though they have no economic interest in the shares. 

The easiest thing to do would be a rule that bans brokers from voting uninstructed shares.  Opposition to this usually centers around the perceived concern that without voting the shares, they will not be deemed present at the meeting for quorum purposes.  To the extent a company lacks a quorum, it will have to reschedule and hold another meeting, causing additional delay and cost.

As a result, brokers are allowed to vote uninstructed shares.  Rule 452 delineates the circumstances where they are not allowed to do so.  Thus, if something is not listed in the Rule, brokers can vote the uninstructed shares.  Rule 452 in turn contains a complicated list of 21 items, including such matters as those relating to "executive compensation," something that, according to the notes, encompasses say on pay. 

The Rule has undergone considerable revision over the years.  An Information Memorandum issued by the NYSE effectively continues this process.  It prohibits brokers from voting uninstructed shares for certain corporate governance provisions even when supported by management.  We will discuss this interpretation in the next post.  


Sterling v. Nestlé: Defendant Lacked Injury and Therefore, Lacked Standing

In Sterling Merch., Inc. v. Nestlé, S.A., 656 F.3d 112 (1st Cir. 2011), the First Circuit Court of Appeals upheld summary judgment in favor of Nestlé, S.A. (“Nestlé”) for lack of standing. Sterling Merchandising Inc. (“Sterling”) sued Nestlé and its subsidiaries for violating the Clayton Act, 15 U.S.C. §§ 12-27, the Sherman Act, 15 U.S.C. §§ 1-7, antitrust laws, and various Puerto Rican laws.  On June 23, 2010, the United States District Court of Puerto Rico granted summary judgment in favor of Nestlé. Sterling subsequently filed this appeal.

In the complaint, Sterling alleged that Nestlé engaged in anti-competitive conduct from June 2003 through October 2009. Sterling contested the Nestlé merger with Payco Foods Corporation (“Payco”) in 2003 that made Nestlé the largest ice cream distributor in Puerto Rico and making Sterling the second largest distributor.  The Puerto Rico Office of Monopolistic Affairs approved the merger upon stipulated conditions. Sterling did not allege breach of any of those conditions.  Instead, Sterling presented a two-part injury and damages theory.  First, Sterling alleged that but-for Nestlé’s exclusivity agreements with a multitude of grocery stores, Sterling missed out on an additional $21-29 million in gross sales.  Second, Sterling alleged that Nestlé’s merger limited Sterling’s market share and caused a decrease in efficient operations.

The district court found that the Puerto Rico ice cream distribution market expanded during the relevant time period, the merger did not restrict output, consumer prices did not increase, and on certain products consumer prices actually decreased. The record also showed that before the merger, Payco and Nestlé had a combined 85% market share, and by 2007, the combined market share fell to 70%.  Sterling’s market share on the other hand, increased from 14.7% in 2003 to 22% in 2008.  Sterling’s sales, which declined $1.06 million from 2001 to 2003, increased after the merger at an average of 11% a year.  

To determine whether Sterling had standing, the court considered “(1) the causal connection between the alleged antitrust violation and harm to the plaintiff; (2) an improper motive; (3) the nature of the plaintiff’s alleged injury and whether the injury was of a type that Congress sought to redress with the antitrust laws (‘antitrust injury’); (4) the directness with which the alleged market restraint caused the asserted injury; (5) the speculative nature of the damages; and (6) the risk of duplicative recovery or complex apportionment of damages.”

The First Circuit applied the Supreme Court’s six-factor standing test, and emphasized causation of the injury.  The court reinforced that, “absence of ‘antitrust injury’ will generally defeat standing” and measured injury by a decrease in output and an increase in prices in the relevant market.  Sterling’s expert failed to show evidence that output within the Puerto Rico ice cream market declined or that consumer prices increased after the merger.  In addition to the findings that the Puerto Rico ice cream market statistics did not support Sterling’s argument, Sterling could not attribute any injury directly caused by Nestlé.  Sterling argued that a “plaintiff’s post-violation successes do not necessarily preclude compensation.” However, the First Circuit disagreed with Sterling’s alternatives to the classic evidence of antitrust injuries.

Sterling also failed to show the requisite injury. Under §2 of the Sherman Act, Sterling must show that Nestlé’s monopoly power prevented competitors from entering the market.  However, new competitors entered the Puerto Rico ice cream market after the merger.  Without establishing any injury to itself or to the competiveness of the market, Sterling’s claims lacked standing.

The primary materials for this case may be found on the DU Corporate Governance website.


The SEC, the Business Roundtable and an Appropriate Alliance

The Business Roundtable sought permission to file an amicus brief on the side of the SEC in the Citigroup case.  We have posted the brief on the DU Corporate Governance web site. 

At first glance, this may seem to be the case of strange bedfellows.  After all, it was the Business Roundtable that challenged the SEC’s shareholder access rule and essentially helped generate an opinion from the DC Circuit that will bedevil rulemaking endeavors for years to come. For an article criticizing that decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

But in fact the connection is a natural one.  To see the two as strange bedfellows is to see the role of the SEC as anti-business.  It is not.  The Commission’s goal of ensuring efficient capital markets benefits all participants.  It may be the case that in ensuring an appropriate regulatory regime the Commission sometimes tilts in favor of investors and shareholders.  But this is in large part a consequence of a shareholder unfriendly regulatory environment in Delaware.  It is a restoration of a necessary balance. 

Still, it seems as if the Business Roundtable and the SEC often find themselves on opposite sides.  Shareholder access is an obvious example.  What explains this?  It is not that one has a pro and the other an anti -business approach to regulation.  The difference is horizon. 

In the shareholder access case, those challenging access essentially sought to preserve the status quo.  The status quo is that directors are nominated by the board (often with considerable influence from the CEO, something chronicled in Essay: Neutralizing the Board of Directors and the Impact on Diversity) and elected by shareholders in a Soviet style contest (this is true even with majority vote provisions). 

As a result, directors often do not represent the interests of shareholders.  Under this electoral approach, there have been repeated breakdowns at the board level that have spurred calls for additional regulation, whether the failure to monitor for fraud that contributed to the pressure for Sarbanes Oxley or the failure to monitor for risk that contributed to the adoption of Dodd Frank. 

The status quo leaves in place a system that has resulted in a cycle of board failure followed by federal intervention and increased regulation.   Certainly this can be seen most clearly in the area of executive compensation, with the SEC now regulating compensation committees, overseeing say on pay, policing clawbacks, and banning practices that induce excessive risk taking.

Access alters the status quo but it also likely alters the cycle of board failure followed by increased federal regulation.  Access, under the model put forward by the SEC, limited the authority to long term investors and only permitted the election of a minority of directors on the board.  The presence of these directors in the boardroom would likely result in increased oversight of critical areas such as risk management and executive compensation.  Access challenges would also provide shareholders with an outlet for their frustration with management and reduce the need to seek a regulatory solution. 

Finally, the presence of shareholder nominated directors would probably stiffen the spine of the remaining directors and, at least in some cases, increasing the degree of oversight.  Under the current configuration, no one on the board wants a reputation as a trouble maker or someone who can be counted on to oppose the CEO.  This no doubt stifles genuine disagreement.  But if the disagreement is initiated by shareholder nominated directors, the others have more room to participate.

In other words, access holds the promise that by changing the status quo the inevitable dynamic of board failure followed by increased regulation will be allayed.  It is a long term benefit but one that trumps the short term consequences.  For now, however, the status quo remains in place and, as a result, so does the cycle of breakdown and regulation. 


The Elimination of Glass Steagall, the Harm to the US Capital Markets, and the Decline in IPOs

As Congress debates how to handle derivatives by large financial institutions, lost in the debate is the structural harm to the capital markets that resulted from the repeal Glass Steagall. 

Glass-Steagall separated commercial banking and securities activities.  Essentially, investment banks received a monopoly on equity offerings and had every incentive to promote active capital markets.   The end of Glass Steagall allowed commercial banks to enter the securities markets essentially without limit. 

As was easy enough to predict, commercial banks would eventually oust investment banks from the area.  Commercial banks have inherent advantages including access to deposits and the discount window.  This financial crisis left only two large free standing investment banks in place (Goldman and Morgan Stanley, although both have converted to commercial banks).  Gone were Lehman, Merrill (now a sub of BofA) and Bear Sterns (acquired by JP Morgan). 

Why does it matter?  Commercial banks are more conservatively managed (particularly given the regulatory oversight of the Federal Reserve Board) and have a conflict of interest.  They have an incentive to encourage lending relationships rather than equity offerings.  Mostly, though, they are not singularly committed to the capital markets and more risk averse.  

Where might this disappearance of the investment banks show up?  In the market for equity IPOs.  Numbers have improved from last year but are still anemic, nowhere near the levels of 2007.  Many are trading in the secondary market at prices below the offering price.  One source recently described the IPO market in the US as "just plain broken." Perhaps the decline in the number of large independent investment banking firms is part of what is broken in the equity markets. 

The reality is that sometimes regulation helps the markets function better.   A knee jerk position that regulation is always bad and must be minimized is not particularly consistent with vibrant capital markets.  Repealing Glass Steagall may be a good example of that mistaken view. 

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